Dave's thoughts on whatever happens to be passing through the transom of his mind.

20101216

Millionaires in the Mist

I've finally gotten around to reading the classic book, The Millionaire Next Door. My timing certainly could have been better, because a new edition just came out last month. And that's significant, because there are a few things they mentioned, where I just had to say that it was out of date. I'll come back to that.

I should also mention that I haven't yet finished it (I'm about halfway through it), but still wanted to put a bunch of thoughts down.

While I'm not disputing any of the books' central theses, I have a number of issues around the edges.

But before I get to those, let's talk about the positives.

Most of the book is talking about good habits. In particular, living below your means (and especially not buying status symbols; I really like the phrase they mention, "Big Hat, No Cattle"), budgeting, and planning ahead. And these are all vital things for getting ahead.

I loved some of the facts and figures they were throwing out. Only about a fifth of millionaires inherited the wealth (note that the current destruction of the estate tax will likely increase this percentage), and only five percent of millionaires make over a $1M annually. Not many of them get the money via sports, entertainment, or lottery, too.

One, they push a number of times how self-employment correlates highly with bring a millionaire. The problem I have with that is one of selection bias. When you only talk to the rich, you only find the successful self-employed. It ignores the many people whose business failed. How much does that change things? I really don't know. The figures I've heard bandied about say something like 80% of small businesses fail within five years. So to say that self-employment correlates with being a millionaire, you need to account for all those people whose businesses failed. A good first step would be to ask those millionaires how many businesses they tried before succeeding. But even that would leave the question significantly unexplored.

Two, they mention education, particularly grad school, correlating negatively with wealth building, owing to starting later to accumulate money. This is another selection bias, as income correlates very highly with education, but not as much with wealth. Which leads me to believe that your best bet is to be highly educated, but not to spend profligately. It's a whole lot easier to save $1M if you're making $180k, rather than $90k. But as they point out with many examples, you can do it by making $90k.

And I think that's the most valuable part of the book; the wealth of examples of both good and bad.

Also, I should point out that technical disciplines in grad school churn out a lot of the people who found tech startups. And those are a major engine of growth over the last decade and a half. And many people got very rich off of them.

Three, they seem to discourage wealth building via home ownership. I'm not sure if that was their intention, but that's the way it sounded to me. The problem with doing things this way is that your assets aren't liquid, but you do generally earn good returns. They especially seemed to disparage buying in wealthy neighborhoods, but there's two reasons to be skeptical about that.

The first problem with avoiding those neighborhoods is that you end up having to pay for private education. Not that I'm entirely against private education; I mostly went to private schools growing up. But they are pretty expensive, and moving to a place with good public schools (if feasible; I realize that it isn't feasible everywhere) can easily pay for itself (especially if you have multiple children).

The second problem is that the expensive neighborhoods tend to go up in value better. My parents always told me that the best way to make money on real estate is to buy the cheapest house in the most expensive neighborhood you can afford. That way the more expensive, surrounding houses will pull the value of your house up. This problem could be seen, much more magnified than usual, in the recent housing crisis, as those neighborhoods have fewer foreclosures. This means that the value in those neighborhoods might drop 10-15%, rather than 30-50%.

So I disagree with them about avoiding expensive housing. I'd still stick with the advice I got from my parents. The only caveat I'd give, is to do your own calculations on how much you can afford. Don't believe the loan officer. Also, unless you have strong reason to believe you're going to sell or refinance pretty soon (or if interest rates are extremely high, I suppose; I haven't been in the housing market when that was the case), don't do ARMs. Just get a 15- or 30-year fixed loan. You might lose a tiny amount of money on a refi, but it isn't worth the possibility of losing lots of money if you don't (or can't) sell or refi.

So what was out of date about the old book? The single biggest thing was when they were talking about how easy it is to go from being poor to being rich in the US. They talked this up for a bit, but the simple fact of the matter is that that is no longer the case. In fact, it was already starting to not be the case when the original edition was written, but the tax changes since then have really cemented that. George Carlin called it.

Here's an interesting graphic about it from the NYT, using 1988 to 1998 data. Select 'Income Mobility' tab. Then hit 'NEXT' to see the change in mobility over the 70s, 80s, and 90s.

I mentioned in a previous post an OECD report, though I wasn't able to find it at the time. It is located here. See the title of Figure 5-10, in particular. And then note that income inequality is as large as it has ever been, with CEOs making, on average, more than 200x the amount of the lowest-paid worker. See more details here, here, and here.

Ok, I'm getting away from the point here. I'll get the newer edition and finish the book, then I'm sure I'll have a bit more to say about it.